Anatomy of the Financial Crisis with comments on Acemoglu, Brunnermeier, El-Erian, & Portes Jeffrey Frankel Harpel Professor of Capital Formation & Growth.

Anatomy of the Financial Anatomy of the Financial CrisisCrisis

with comments onwith comments onAcemoglu, Brunnermeier, Acemoglu, Brunnermeier,

El-Erian, & PortesEl-Erian, & Portes

Jeffrey FrankelJeffrey FrankelHarpel Professor of Capital Formation & GrowthHarpel Professor of Capital Formation & Growth

Harvard Kennedy SchoolHarvard Kennedy School

Meeting of Commission on Growth & Development

at Center for International Development, April 20-21, at Center for International Development, April 20-21, 20092009

2

Six root causes of financial Six root causes of financial crisiscrisis

1. US1. US corporate governance falls corporate governance falls shortshort E.g., rating agencies; E.g., rating agencies; executive compensationexecutive compensation

options; options; golden parachutes…golden parachutes…

2. US households save too little,2. US households save too little, borrow too much.borrow too much.

3.3. Politicians slant excessively Politicians slant excessively toward toward homeownershiphomeownership

Tax-deductible mortgage interest, cap.gains; Tax-deductible mortgage interest, cap.gains; FFannieannieMMae & Freddie Macae & Freddie Mac; ; Allowing teasers, Allowing teasers, NINJANINJA loans, liar loans… loans, liar loans…

MSN Money & Forbes

3

Six root causes of financial crisis,Six root causes of financial crisis, cont.cont.

4. Starting 2001, the 4. Starting 2001, the federal budgetfederal budget was set on a reckless path,was set on a reckless path,

reminiscent of 1981-1990reminiscent of 1981-1990

5. Monetary policy was too loose 5. Monetary policy was too loose during 2004-05,during 2004-05,

accommodating fiscal expansion,accommodating fiscal expansion, reminiscent of the Vietnam era.reminiscent of the Vietnam era.

6. Financial market participants during 6. Financial market participants during this period grossly this period grossly underpriced riskunderpriced risk risks: risks:

housing crash, housing crash, $ crash, $ crash, oil prices, oil prices, geopolitics….geopolitics….

4

Current account Current account imbalancesimbalances Richard Portes: “Global Imbalances caused crisis.”Richard Portes: “Global Imbalances caused crisis.”

=> low volatility and interest rates => leverage.=> low volatility and interest rates => leverage. I disagree.I disagree.

I view low US National Saving as main source of I view low US National Saving as main source of CA.CA. I agree with Richard this crisis is not the feared US I agree with Richard this crisis is not the feared US

sudden stop sudden stop That’s the That’s the nextnext crisis. crisis.

But then why interest rates low? Easy money. But then why interest rates low? Easy money. (Like (Like 1960s.)1960s.)

Many disagree Many disagree (My “9 Reasons…” for Growth Commission)(My “9 Reasons…” for Growth Commission) Global savings glut hypothesis Global savings glut hypothesis (Bernanke…)(Bernanke…)

But measured world saving did not rise in this decade.But measured world saving did not rise in this decade. Bretton Woods II Bretton Woods II (Dooley, Garber…)(Dooley, Garber…) . .

But BW I operated for only 14 years. We’re near the end.But BW I operated for only 14 years. We’re near the end. US offers the high-quality assets. US offers the high-quality assets. (Forbes, Gourinchas, Caballero..)(Forbes, Gourinchas, Caballero..)

Not really. Was clear in 2001 (Enron…)Not really. Was clear in 2001 (Enron…)

5

But I would think herd mentality – the opposite of heterogeneous views -- would be the bigger problem.

Yes.Note: time-varying variance itself gives fat tails.

Yes. We thought securitization of mortgages would “spread the risk.” But it spread risk like a virus !

6

I would like to suggest a fourth “new” idea in volatility: When using Black-Scholes or other formulas to price options (VIX) or bond spreads (corporate bonds), analysts simply plug in variance estimated from the recent past.During 2004-2006, lagged variance was low, tho forward-looking risk was high.

7

As Adrian & Brunnermeier As Adrian & Brunnermeier point outpoint out (p.5),(p.5), ““After a string of good news, risk seems tamed, but, After a string of good news, risk seems tamed, but,

when a new tail event occurs, the estimated risk measure when a new tail event occurs, the estimated risk measure may sharply increase. This problem is most pronounced may sharply increase. This problem is most pronounced if the data samples are short. Hence, regulatory if the data samples are short. Hence, regulatory requirements that are naively based on estimated risk requirements that are naively based on estimated risk measures would be stringent during a crisis and lax measures would be stringent during a crisis and lax during a boom. This introduces procyclicality – during a boom. This introduces procyclicality – exactly the opposite of the goal of effective regulation.”exactly the opposite of the goal of effective regulation.”

I couldn’t agree more. But: (i) Does this require that tail events are asymmetrically negative? (ii) If so, could the causality run from a variance innovation, via the risk premium, to a fall in asset prices, instead of the other way?

8

Monetary policy easy

2004-05

Federal budget deficits

Underestimated

risk in financial mkts

Failures of corporate

governance

Households saving too little, borrowing too

much

Excessive leverage in financial institutions

Stockmarketbubble

Housing

bubble

Stock marketcrash

HousingcrashFinancial

crisis2007-08

China’s growth

Low national saving

Lower long-term

econ.growth

Eventual loss of US hegemony

Recession2008-09

Oil price spike2007-08

Gulfinsta-bility

Foreign debt

Origins of the Origins of the financial/economic crisesfinancial/economic crises

Excessive complexity

CDSsMBSs

CDOs

Predatory lending

Homeownership bias

9

The return of KeynesThe return of Keynes

Keynesian truths abound today:Keynesian truths abound today: Origins of the crisisOrigins of the crisis The Liquidity TrapThe Liquidity Trap Fiscal responseFiscal response Motivation for macroeconomic Motivation for macroeconomic

intervention:intervention:to save market microeconomicsto save market microeconomics

International transmissionInternational transmission Need for macroeconomic coordinationNeed for macroeconomic coordination

10

The origin of the crisis was an asset bubble The origin of the crisis was an asset bubble collapse, loss of confidence, credit crunch….collapse, loss of confidence, credit crunch….

like Keynes’ animal spirits or beauty contestlike Keynes’ animal spirits or beauty contest . . Add in von Hayek’s credit cycle, Add in von Hayek’s credit cycle, KindlebergerKindleberger78 78 ’s “manias & panics”’s “manias & panics” the “Minsky moment,” &the “Minsky moment,” & Fisher’s “debt deflation.”Fisher’s “debt deflation.”

It was It was notnot a monetary contraction a monetary contraction in response to inflationin response to inflation as were 1980-82 or 1991.as were 1980-82 or 1991.

But, rather, a credit cycle: 2003-04 monetary But, rather, a credit cycle: 2003-04 monetary expansion showed up only in asset prices. expansion showed up only in asset prices. (Borio of BIS.)(Borio of BIS.)

11

Financial regulation

Good for Daron !

True.But if we don’t draw up an informed list, politicians will come up with a worse one.

12

Desirable longer-term financial reformsDesirable longer-term financial reforms

Executive compensation Executive compensation Compensation committee not under CEO. Maybe need Compensation committee not under CEO. Maybe need

Chairman of Board.Chairman of Board. Discourage golden parachutes & options, unless truly tied to Discourage golden parachutes & options, unless truly tied to

performance.performance. SecuritiesSecurities

Regulatory agencies: Regulatory agencies: In US, merge SEC & CFTC?In US, merge SEC & CFTC? Create a central clearing house for CDSs .Create a central clearing house for CDSs . Credit ratings: Credit ratings:

Reduce reliance on ratings. AAA does not mean no risk.Reduce reliance on ratings. AAA does not mean no risk. Reduce ratings agencies’ conflicts of interest.Reduce ratings agencies’ conflicts of interest.

LendingLending MortgagesMortgages

Consumer protection, incl. standards for mortgage brokersConsumer protection, incl. standards for mortgage brokers Fix “originate Fix “originate to to distribute” model, so lenders stay on distribute” model, so lenders stay on the the hook.hook.

Banks: Banks: Regulators shouldn’t let banks use their own risk models Regulators shouldn’t let banks use their own risk models (VAR);(VAR); should make capital requirements less pro-cyclical .should make capital requirements less pro-cyclical .

Extend bank-like regulation to “near banks.”Extend bank-like regulation to “near banks.”

Heavy

overlap

with Richar

d Porte

s’list, FT,

11/11/08

13

I always thought CoVar stood for Covariance. But that is no more – nor less – confusing than VAR standing for Value at Risk instead of either Variance or Vector AutoRegression.In fact CoVaRiance rather captures the spirit of the idea.Adrian & Brunnermeier make the sensible point that regulators should worry about how much a bank contributes to systemic risk (CoVaR), more than just own risk (VaR).

Analogous to a CAPM for regulators.

14

Lehman Brothers, whose failure inflicted maximum adverse effect on the financial system in Sept. 2008, shows up with almost the highest risk rating by CoVaR, but also by VaR.

15

I would phrase it: We have learned something we should have already known -- financial markets need a lot of regulation, but market capitalism still works best in the real economy.

16

Motivation for macroeconomic Motivation for macroeconomic interventionintervention

The view that Keynes stood for The view that Keynes stood for big government is not really right.big government is not really right. He wanted to save market microeconomics from He wanted to save market microeconomics from

central planning, which had allure in the 30s & 40s.central planning, which had allure in the 30s & 40s. Remember, Bretton Woods blessed Remember, Bretton Woods blessed

capital controls capital controls and and free trade.free trade.

Some on the Left today reacted to the crisis & Some on the Left today reacted to the crisis & election by hoping a new New Deal would election by hoping a new New Deal would overhaul the economy.overhaul the economy. My view: faith in the unfettered capitalist system has My view: faith in the unfettered capitalist system has

been shaken been shaken with respect to financial markets, true; with respect to financial markets, true; but not with respect to the rest of the economy; but not with respect to the rest of the economy;

Obama’s economics are centrist, not far left.Obama’s economics are centrist, not far left.

17

International transmission remains International transmission remains as powerful as ever (no “de-as powerful as ever (no “de-coupling”)coupling”) Consistent with old-fashioned Keynes-Meade-Consistent with old-fashioned Keynes-Meade-

Mundell-Fleming transmission via trade Mundell-Fleming transmission via trade balances.balances.

18

International coordinationInternational coordinationof fiscal expansion?of fiscal expansion?

As in the classic Locomotive TheoryAs in the classic Locomotive Theory

Theory:Theory: in the Nash non-cooperative in the Nash non-cooperative equilibriumequilibrium each country holds back from fiscal expansioneach country holds back from fiscal expansionfor fear of adverse trade deficits.for fear of adverse trade deficits. Solution: A bargain where all expand together.Solution: A bargain where all expand together.

In practice:In practice: example of Bonn Summit, example of Bonn Summit, 19781978 didn’t turn out so well,didn’t turn out so well, primarily because inflation turned out to be a bigger primarily because inflation turned out to be a bigger

problem than realized (& the German world was non-problem than realized (& the German world was non-Keynesian).Keynesian).

Inflation is less a problem this time. The Germans are the Inflation is less a problem this time. The Germans are the same.same.

19

Multilateral initiativesMultilateral initiatives Hold the line against protectionismHold the line against protectionism Attempts at multilateral reformAttempts at multilateral reform

More inclusion of developing countriesMore inclusion of developing countries Locus shifted from G7 to G20 at London meeting Locus shifted from G7 to G20 at London meeting (April).(April). The IMF and World BankThe IMF and World Bank

Reallocation of sharesReallocation of shares Break US-EU duopoly on MD & PresidentBreak US-EU duopoly on MD & President Tripling of size of IMF, incl. new SDR issue Tripling of size of IMF, incl. new SDR issue (a la Keynes)(a la Keynes)

Regulatory reform. Regulatory reform. Reduce procyclical Basel capital requirements; FSF; ….Reduce procyclical Basel capital requirements; FSF; ….

Coordinated expansion? Failed at London G-Coordinated expansion? Failed at London G-20.20.

As had cooperation in 1933 As had cooperation in 1933 (London Monetary & Economic (London Monetary & Economic Conference)Conference)

20

USfiscal

stimulus

looks the

largest of

the G-10.

than the US But most others have larger automatic stabilizers

21

Mohamed El-Elrian & Mike Mohamed El-Elrian & Mike Spence,Spence,

“Essential Task for G20 “Essential Task for G20 Leaders is a Cinema Trip to Leaders is a Cinema Trip to

See See A Beautiful Mind”A Beautiful Mind”The Daily Telegraph, March 30, 2009The Daily Telegraph, March 30, 2009

Apparently Mohamed and Mike think Apparently Mohamed and Mike think the producers of that movie took the the producers of that movie took the opportunity to teach the audience the opportunity to teach the audience the simple principle of the prisoner’s dilemma. simple principle of the prisoner’s dilemma. A reasonable inference. A reasonable inference.

But that’s not how I remember the movie.But that’s not how I remember the movie.Hollywood doubts the analytical aptitude/interests of the public.Hollywood doubts the analytical aptitude/interests of the public.

22

23

AppendicesAppendices Origins of the crisisOrigins of the crisis The US recessionThe US recession Transmission to rest of worldTransmission to rest of world Global forecastGlobal forecast The US policy responseThe US policy response

Monetary easingMonetary easing Financial repairFinancial repair Fiscal expansionFiscal expansion

Global current account imbalancesGlobal current account imbalances Implications of the crisis for the status of the Implications of the crisis for the status of the

dollardollar Adjustment in surplus countriesAdjustment in surplus countries

End of the 3End of the 3rdrd emerging markets capital emerging markets capital boomboom

24

Origins of the crisisOrigins of the crisis Well before 2007, Well before 2007,

there were danger there were danger signals in US:signals in US: Real interest rates <0 , Real interest rates <0 ,

2003-04 ; 2003-04 ; Early corporate scandals Early corporate scandals

(Enron…);(Enron…);

Risk was priced very low, Risk was priced very low,

housing prices very high, housing prices very high, National Saving very low,National Saving very low, current account deficit big,current account deficit big, leverage high,leverage high, mortgages imprudent…mortgages imprudent…

25

US real interest rate < 0, US real interest rate < 0, 2003-042003-04Source: Benn Steil, CFR, March 2009

26

Onset of the crisisOnset of the crisis Initial reaction to troubles:Initial reaction to troubles:

Reassurance in mid-2007: “The subprime Reassurance in mid-2007: “The subprime mortgage crisis mortgage crisis is contained.” is contained.” It wasn’t.It wasn’t.

Then, “The crisis is in Wall Street, sparing Then, “The crisis is in Wall Street, sparing Main Street.” Main Street.” It didn’t.It didn’t.

Then Then de-couplingde-coupling : : “The US turmoil will have less effect on the “The US turmoil will have less effect on the rest rest of the world than in the past.” of the world than in the past.” It hasn’t.It hasn’t.

By now it is clear that the crisis is By now it is clear that the crisis is the worst in 75 years, the worst in 75 years, and is as bad abroad as in the US.and is as bad abroad as in the US.

27

US RecessionUS Recession

In December 2008, NBER Business In December 2008, NBER Business Cycle Dating Committee proclaimed Cycle Dating Committee proclaimed US recession had started in December US recession had started in December

2007.2007.

As of March 2009, the recession’s length As of March 2009, the recession’s length ties the postwar record of 1981-82 ties the postwar record of 1981-82 (16 (16 months).months). Recovery unlikely before late 2009Recovery unlikely before late 2009 => recession is already longest since 1930s.=> recession is already longest since 1930s.

Likely also to be as severe as oil-shock Likely also to be as severe as oil-shock recessions of 1974 and 1980-82.recessions of 1974 and 1980-82.

28

BUSINESS CYCLE REFERENCE DATESBUSINESS CYCLE REFERENCE DATES   Source: NBERSource: NBER

PeakPeak TroughTrough ContractioContractionn

Quarterly dates are in parenthesesQuarterly dates are in parentheses Peak to TroughPeak to Trough

August 1929 (III)August 1929 (III)May 1937 (II)May 1937 (II)February 1945 (I)February 1945 (I)November 1948 (IV)November 1948 (IV)July 1953 (II)July 1953 (II)August 1957 (III)August 1957 (III)April 1960 (II)April 1960 (II)December 1969 (IV)December 1969 (IV)November 1973 (IV)November 1973 (IV)January 1980 (I)January 1980 (I)July 1981 (III)July 1981 (III)July 1990 (III)July 1990 (III)March 2001March 2001 (I) (I)December 2007December 2007 (IV) (IV)

March 1933 (I)March 1933 (I)June 1938 (II)June 1938 (II)October 1945 (IV)October 1945 (IV)October 1949 (IV)October 1949 (IV)May 1954 (II)May 1954 (II)April 1958 (II)April 1958 (II)February 1961 (I)February 1961 (I)November 1970 (IV)November 1970 (IV)March 1975 (I)March 1975 (I)July 1980 (III)July 1980 (III)November 1982 (IV)November 1982 (IV)March 1991March 1991 (I) (I)November 2001November 2001 (IV) (IV)

434313138811111010881010111116166616168888

Average, all cycles:Average, all cycles: 1854-2001 (32 cycles) 1854-2001 (32 cycles)

1945-2001 (10 cycles)1945-2001 (10 cycles)

1717

1010

29

US employment peaked in Dec. 2007,which is the most important reason why

the NBER BCDC dated the peak from that month.

Since then, 5 million jobs have been lost (4/3/09).

Payroll employment series Source: Bureau of Labor StatisticsPayroll employment series Source: Bureau of Labor Statistics

30

My favorite monthly indicator:My favorite monthly indicator:total hours worked in the total hours worked in the

economyeconomy

It confirms: US recession turned severe in September, when the worst of the financial crisis hit (Lehman bankruptcy…)

31

The US recession so far is The US recession so far is deepdeep

compared to past and to compared to past and to others’others’

Source: IMF, Source: IMF, WEOWEO, April 2009, April 2009

32

Recession was soon Recession was soon transmittedtransmitted

to rest of world: to rest of world: Contagion: Falling securities Contagion: Falling securities

markets & contracting credit.markets & contracting credit. Especially in those countries with weak fundamentals: Especially in those countries with weak fundamentals:

Iceland, Hungary & Ukraine…Iceland, Hungary & Ukraine… Or oil-exporters that relied heavily on high oil prices: Russia…Or oil-exporters that relied heavily on high oil prices: Russia… But even where fundamentals relatively strong: Korea, Brazil…But even where fundamentals relatively strong: Korea, Brazil…

Some others experiencing their own housing Some others experiencing their own housing crashes:crashes: Ireland, Spain…Ireland, Spain…

Recession in big countries was soon transmitted Recession in big countries was soon transmitted to all trading partners through loss of exports. to all trading partners through loss of exports.

33

Source: OECD

International Trade has Plummeted

34

The recession has hit more The recession has hit more countries than any in 60 countries than any in 60

yearsyears

35

Forecasts

36

Interim forecastInterim forecast OECD OECD 3/13/093/13/09

Forecastfor 2009 = - 3 ½ %

37

““WorldWorld Recession” Recession”

No generally accepted definition.No generally accepted definition. A sharp fall in China’s growth from 11% is a A sharp fall in China’s growth from 11% is a

recession. recession. Usually global growth < 2 % is considered a Usually global growth < 2 % is considered a

recession.recession.

The World Bank now The World Bank now (March)(March) forecasts forecasts negative global growth in 2009,negative global growth in 2009, for the first time in 60 years.for the first time in 60 years.

38

Unemployment rates are rising Unemployment rates are rising everywhereeverywhere

39

Do Do we knowwe know this won’t this won’t be anbe anotherother Great Great

Depression?Depression? One hopes we won’t repeat the mistakes of One hopes we won’t repeat the mistakes of

the 1930s.the 1930s.

Monetary responseMonetary response:: good this time good this time

Financial regulationFinancial regulation:: we already have bank we already have bank regulation regulation to prevent runs. But it is clearly not enough.to prevent runs. But it is clearly not enough.

Fiscal responseFiscal response:: OK, OK, but but : : constrained constrained by inherited debt. Also Europe was by inherited debt. Also Europe was unwilling to match our fiscal stimulus at G-20 summit.unwilling to match our fiscal stimulus at G-20 summit.

Trade policy: Let’s not repeat Smoot-Hawley !Trade policy: Let’s not repeat Smoot-Hawley ! E.g., the Buy America provisionE.g., the Buy America provision Mexican trucksMexican trucks

40

The Fed certainly hasn’t The Fed certainly hasn’t repeated the mistake of repeated the mistake of 1930s: letting M1 fall.1930s: letting M1 fall.

SourcSource: e:

IMF, IMF, WEOWEO, , April April 20092009Box Box 3.13.1

1930s

2008-09

41

U.S. Policy U.S. Policy ResponsesResponses

MonetaryMonetary easing is unprecedented, easing is unprecedented, appropriately. But it has largely run its appropriately. But it has largely run its course:course:

Policy interest rates ≈ 0.Policy interest rates ≈ 0. (graph)(graph)

The famous liquidity trip is not mythical after all.The famous liquidity trip is not mythical after all. As Krugman & others warned us re Japan in 90s.As Krugman & others warned us re Japan in 90s.

& lending, even inter-bank, builds in big spreads& lending, even inter-bank, builds in big spreads since mid-2007, not just since September 2008.since mid-2007, not just since September 2008. (graph)(graph)

Now aggressive quantitative easing, as the Fed Now aggressive quantitative easing, as the Fed continues to purchase assets not previously continues to purchase assets not previously dreamt of.dreamt of.

42

Source: OECDMajor central banks have cut interest Major central banks have cut interest rates sharply.rates sharply.

43

Bank spreads rose sharplyBank spreads rose sharplywhen sub-prime mortgage crisis hit (Aug. when sub-prime mortgage crisis hit (Aug.

2007) 2007) and up again when Lehman crisis hit (Sept. and up again when Lehman crisis hit (Sept.

2008).2008).

Source: OECD,Datastream

44

Corporate spreadsCorporate spreads between corporate & government between corporate & government

benchmark bondsbenchmark bonds zoomed after zoomed after Sept. 2008Sept. 2008

US

€

45

Policy Responses,Policy Responses, continuedcontinued

Obama policy of Obama policy of “financial repair”:“financial repair”:Infusion of funds has been more conditional,Infusion of funds has been more conditional,

vs. Bush Administration’s no-strings-attached. vs. Bush Administration’s no-strings-attached. Some money goes to reduce foreclosures.Some money goes to reduce foreclosures. Conditions imposed on banks that want help:Conditions imposed on banks that want help:

(1) no-dividends rule,(1) no-dividends rule, (2) curbs on executive pay, (2) curbs on executive pay, (3) no takeovers, unless at request of authorities &(3) no takeovers, unless at request of authorities & (4) more reporting of how funds are used.(4) more reporting of how funds are used.

But so far they have avoided “nationalization” But so far they have avoided “nationalization” of banksof banks

46

Secretary Geithner announced PPIP 3/23/09: Secretary Geithner announced PPIP 3/23/09: Public-Private Partnership Investment Public-Private Partnership Investment ProgramProgram When buying “toxic” or “legacy assets” When buying “toxic” or “legacy assets” from

banks, their prices are to be set by private bidding

(from  private equity, hedge funds, and others), rather than by an overworked Treasury official pulling

a number out of the air and risking that taxpayers grossly overpay for the assets, as under TARP.  

Policy Responses -- Financial Policy Responses -- Financial

Repair,Repair, cont.cont.

47

How much money is the government putting into the PPIP?designed to be enough to attract participants, but not

more.From the Treasury (already set aside under TARP),

leveraged courtesy of FDIC & Fed.Taxpayers

share equally with new private investors in upside, but admittedly bear all the downside risk.

Nationalization could have been a lot more expensive.

Policy Responses -- Financial Policy Responses -- Financial

Repair,Repair, cont.cont.

48

The PPIP was attacked from The PPIP was attacked from both sidesboth sides

in part due to anger over AIG bonuses, etc.in part due to anger over AIG bonuses, etc.

But the stock market reacted But the stock market reacted very positively, and some very positively, and some

respected commentators are respected commentators are supportive.supportive.

FT, Mar 25, 2009

49

Policy Responses,Policy Responses, continuedcontinued

Unprecedented US Unprecedented US fiscalfiscal expansionexpansion.. Obama proposed an $825 expansion Obama proposed an $825 expansion Version passed by Congress was just a Version passed by Congress was just a

bit worse. bit worse. Good old-fashioned Keynesian stimulusGood old-fashioned Keynesian stimulus

Even the belief that spending provides Even the belief that spending provides more stimulus than tax cuts has more stimulus than tax cuts has returned;returned;

not just from Larry Summers, not just from Larry Summers, for example, for example,

but also from Martin Feldstein.but also from Martin Feldstein.

50

Fiscal responseFiscal response“Timely, targeted and “Timely, targeted and

temporary.”temporary.”

American Recovery & Reinvestment Plan American Recovery & Reinvestment Plan includes:includes:

Aid to states: Aid to states: education, education, Medicaid…; Medicaid…;

Other spending.Other spending. Unemployment benefits, food stamps,Unemployment benefits, food stamps, especially infrastructureespecially infrastructure, and, and

Computerizing medical records, Computerizing medical records, smarter electricity distribution grids, andsmarter electricity distribution grids, and high-speed Internet access.high-speed Internet access.

51

Fiscal stimulus also includedFiscal stimulus also included

Tax cuts Tax cuts for lower-income workers (“Making for lower-income workers (“Making

Work Pay”)Work Pay”) EITC, EITC, child tax credit.child tax credit.

Fix for the AMT Fix for the AMT (for the middle class).(for the middle class). But soon will need to return toward fiscal But soon will need to return toward fiscal

disciplinediscipline Let Bush’s pro-capital tax cuts expire in 2011.Let Bush’s pro-capital tax cuts expire in 2011. Economists want to substitute energy taxes Economists want to substitute energy taxes

for others.for others.

52

The The nextnext crisis crisis

The twin deficits:The twin deficits: US budget deficit => current account deficitUS budget deficit => current account deficit

Until now, global investors have happily financed US Until now, global investors have happily financed US deficits.deficits.

The recent flight to quality paradoxically benefited the The recent flight to quality paradoxically benefited the $,$, even though the international financial crisis originated in the US.even though the international financial crisis originated in the US. For now, US TBills are still viewed as the most liquid & riskless.For now, US TBills are still viewed as the most liquid & riskless.

Sustainable?Sustainable? How long will foreigners keep adding to their $ holdings?How long will foreigners keep adding to their $ holdings? The US can no longer necessarily rely on support of foreign The US can no longer necessarily rely on support of foreign

central banks, either economically or politically.central banks, either economically or politically.

53

The 2007-08 financial crisis The 2007-08 financial crisis has probably further has probably further

undermined US monetary undermined US monetary hegemony in the long runhegemony in the long run

US financial institutions have lost credibilityUS financial institutions have lost credibility Expansionary fiscal and monetary policy may Expansionary fiscal and monetary policy may

show up as $ depreciation in the long run.show up as $ depreciation in the long run. The long slow decline of the $ as an The long slow decline of the $ as an

international reserve currency may international reserve currency may accelerate.accelerate.

5454

Simulation of central banks’ of reserve currency holdings Scenario: accession countries join EMU in 2010. (UK stays out), but 20% of London turnover counts toward Euro financial depth, and currencies depreciate at the average 20-year rates up to 2007.

From Chinn & Frankel (Int.Fin., 2008)

.0

.1

.2

.3

.4

.5

.6

.7

.8

1980 1990 2000 2010 2020 2030 2040

USD

DEM/EUR

USD forecast

EURforecast

Tipping point in updated simulation: 2015

Simulation predicts € may overtake $ as early as 2015

55

Historical precedent: £ Historical precedent: £ ((1914-1956)1914-1956)

With a lag after US-UK reversal of ec. size & With a lag after US-UK reversal of ec. size & net debt, $ passed £ as #1 international net debt, $ passed £ as #1 international currency.currency.

““Imperial over-reach:” the British Empire’s Imperial over-reach:” the British Empire’s widening budget deficits and overly ambitious widening budget deficits and overly ambitious military adventures in the Muslim world.military adventures in the Muslim world.

The 2001-2020 decline in The 2001-2020 decline in international currency status for the international currency status for the

$ would be only one small part of $ would be only one small part of a loss of power on the part of the US. a loss of power on the part of the US.

But: But:A loss of $’s role as #1 reserve A loss of $’s role as #1 reserve currency could in itself have currency could in itself have

geopolitical implicationsgeopolitical implications..

5656

Precedent: The Precedent: The Suez crisis of Suez crisis of 1956 1956 [i][i]

is often recalled as the occasion is often recalled as the occasion on which Britain was forced on which Britain was forced under US pressure to abandon under US pressure to abandon its remaining imperial designs. its remaining imperial designs.

But recall also the important role But recall also the important role played by a simultaneous run on played by a simultaneous run on the the ££ and the American decision and the American decision not to help the beleaguered currency. not to help the beleaguered currency.

[i][i] Frankel, “Could the Twin Deficits Jeopardize US Hegemony,” Frankel, “Could the Twin Deficits Jeopardize US Hegemony,” Journal of Policy ModelingJournal of Policy Modeling, 28, no. 6, Sept. 2006.  , 28, no. 6, Sept. 2006.  At At http://ksghome.harvard.edu/~jfrankel/SalvatoreDeficitsHegemonJan26Jul+.pdfhttp://ksghome.harvard.edu/~jfrankel/SalvatoreDeficitsHegemonJan26Jul+.pdf . .

Also “The Flubbed Opportunity for the US to Exercise Global Economic Leadership”;  Also “The Flubbed Opportunity for the US to Exercise Global Economic Leadership”; 

in in The International Economy, The International Economy, XVIII, no. 2, Spring 2004XVIII, no. 2, Spring 2004 at http://ksghome.harvard.edu/~jfrankel/FlubJ23M2004-.pdfat http://ksghome.harvard.edu/~jfrankel/FlubJ23M2004-.pdf

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““Be careful what you wish for!”Be careful what you wish for!”US politicians have not yet learned US politicians have not yet learned

how dependent on Chinese financing how dependent on Chinese financing we have become.we have become.

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In the short run, however, the In the short run, however, the financial crisis has caused a financial crisis has caused a

flight to quality which flight to quality which apparently still means a flight to apparently still means a flight to

US$.US$. US Treasury bills are more in demand than ever, US Treasury bills are more in demand than ever, as reflected in very low interest rates.as reflected in very low interest rates.

The $ The $ appreciatedappreciated in 2008, rather than depreciating as in 2008, rather than depreciating as the “hard landing” scenario had predicted.the “hard landing” scenario had predicted.

=> The day of reckoning had not yet arrived.=> The day of reckoning had not yet arrived.

Recent Chinese warnings may be a turning point:Recent Chinese warnings may be a turning point: Premier Wen worried US T bills will lose value.Premier Wen worried US T bills will lose value. PBoC Gov. Zhou proposed PBoC Gov. Zhou proposed

replacing $ as international currency.replacing $ as international currency.

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Global Current Account Global Current Account ImbalancesImbalances may now be forced to may now be forced to

adjustadjust

US deficit will likely diminish,US deficit will likely diminish, though adjustment requires $ depreciation.though adjustment requires $ depreciation.

Who must take corresponding Who must take corresponding reduction in current account reduction in current account surpluses?surpluses? Europe says: “Not us. Overall we are in balance.”Europe says: “Not us. Overall we are in balance.” Others say: Europe can expect to take a share, Others say: Europe can expect to take a share,

roughly proportionate to its share in world trade, roughly proportionate to its share in world trade, IMF seems to think oil exporters will take all IMF seems to think oil exporters will take all

adjustment adjustment (see graph)(see graph)

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Current account adjustment:Current account adjustment:US vis-á-vis oil exportersUS vis-á-vis oil exporters

(as % of GWP; (as % of GWP; source: IMF) source: IMF)

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The OECD sees the The OECD sees the €€--area area bearing much of the adjustment.bearing much of the adjustment.

Source: OECD Economic Outlook, Nov. 2008. 3/ as % of GDP

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But But emerging marketsemerging marketsnow have to spend some hard-now have to spend some hard-

earned reservesearned reserves

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3 cycles of net private capital 3 cycles of net private capital flowsflows

to emerging markets, by regionto emerging markets, by regionpeaking in 1982, 1997 and 2008 peaking in 1982, 1997 and 2008

Source: Capital Flows to Emerging Market Economies, IIF, 1/27/09.

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Capital flows to emerging Capital flows to emerging marketsmarkets

peaked in 2007peaked in 2007

from: EM Fund Flows, Citi, December 2008

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Source: Benn Steil, Lessons of the Financial Crisis, CFR, March 2009

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BRIC growth has disappeared

Jeffrey FrankelJeffrey FrankelJames W. Harpel Professor of Capital James W. Harpel Professor of Capital

Formation & GrowthFormation & GrowthHarvard Kennedy SchoolHarvard Kennedy School

http://ksghome.harvard.edu/~jfrankel/ihttp://ksghome.harvard.edu/~jfrankel/index.htmndex.htm

Blog: Blog: http://content.ksg.harvard.edu/blog/jeff_frankels_whttp://content.ksg.harvard.edu/blog/jeff_frankels_weblog/eblog/